No Help From Bonds

By

William Pesek Jr.

Aug. 10, 1998 12:01 a.m. ET

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I t's different this time. That's been the rallying cry of the bulls in this market. And in a sense, the recent stock-market selloff is proving them right. Bear markets almost invariably have resulted from an increase in interest rates engineered by a Federal Reserve that had become worried about rising inflation. With no inflation in sight and prices of goods as likely to be falling as rising, the Fed was unlikely to tighten any time soon.

But the stock market has swooned even as the bond market has brought long-term yields down to the lowest level in more than two decades. Clearly, the bond market is not the cause of the stock market's problems now. Neither is the bond market likely to bail out the stock market.

To be sure, each break in the equity market in recent years has been accompanied by a subsequent rally in bonds. Investors would seek refuge in Treasuries, the highest-quality and most-liquid securities extant, driving up their prices and pushing down their yields. And if effects of the stock selloff were severe enough to threaten the real economy, as in the October 1987 crash, the Fed could be counted on to perform the single most important function of a central bank: to provide rivers of liquidity in such a crisis.

In other words, bad news for stocks was almost always good news for bonds. And the resulting decline in bond yields eventually would put a floor under the equity market. At lower interest-rate levels, stock valuations would return to attractive levels. And given that there was no recession in the offing, the bull market would resume. The self-correcting feedback mechanism helps to explain the longevity of this bull.

But in the current environment, the bond market may not be much help if the Dow Jones Industrial Average continues the recent slide that drove the closely watched barometer down almost 300 points in a single day last week. On the one hand, it can hardly be said that interest rates are hampering the stock market's performance. Nor are interest rates crimping the real economy. Just look at the booming housing market, arguably the most credit-sensitive sector of the economy. But further declines in rates are unlikely given the Fed's oft-stated concerns about rising wages, which makes an easing in monetary policy improbable any time soon. And that's even if equities remain wobbly.

"I don't expect declining bond yields to rescue the stock market this time around," says Dana Johnson of First Chicago.

If history is any guide, the level of interest rates is typically the biggest factor behind the end of a bull market. As rates increase, stocks become a less alluring investment on a relative basis, while companies and households are burdened with higher borrowing costs and so have fewer funds to invest or spend. The upshot is a breakdown in the price/earnings multiple on stocks.

Right now, however, the low current level of interest rates has helped P/Es climb to an unprecedented 25 times estimated 1998 earnings. The benchmark 30-year Treasury bond yield of 5.67% is close to the lowest it's been since the government started regular issuance of that maturity in the mid-'Seventies. More important, perhaps, is the middle of the yield curve, which sets rate levels for most of the private sector, notably the mortgage market. Every Treasury note already trades below the Fed's target of 5 1/2% for federal funds, from 5.37% for the two-year note to 5.43% for the 10-year issue. Without a cut in the fed funds rate -- or strong expectations that one is in the offing -- it's hard to see how intermediate or long yields can fall further from here. Moreover, a Fed rate hike isn't on the horizon. So it's the slowdown in corporate earnings -- and uncertainty about future profits -- that is the immediate concern for stock investors.

Over the last year, the favorable interest-rate environment has enabled the stock market to downplay, even ignore, concerns about earnings. But now, equity investors reluctantly are acknowledging that Asia's problems are taking a bigger bite out of the economy than first advertised. Indeed, executives are more aware than ever of their exposure to Asia, both directly and indirectly. Even companies that don't do business in the region face intense price competition that is the result of collapse of Asian economies. That salutary effect on inflation, however, is already fully built into the interest-rate structure.

The bond market's influence in the stock market's ups and downs usually is significant. One of the principal arguments that explains the stock rally of the past four years is that the level of the stock market, rather than being a function of earnings alone, is in fact a product of several other important factors, notably interest rates and the so-called equity risk premium. The latter, which attempts to measure the extra return stock investors demand for the extra risk they bear, has steadily declined as the result of investors' ever-growing confidence in equities.

In a new study, Laurence Mutkin of Tokai Bank argues that while it's natural that bond-market returns are correlated with changes in bond yields, stock-market returns are also correlated with changes in bond yields, albeit to a lesser extent. This connection increasingly is coming to light at a time when more traditional methods of valuing the stock market, using some measure of corporate earnings growth, have conspicuously failed to predict the acceleration in the stock market rally since 1994. All of this makes a strong case for examining more closely the effect of interest rates on stock-market valuations, Mutkin says.

"We are more than happy to agree not only that the level of interest rates influences equity valuations, but also that this influence may be very large and in some circumstances may have a greater bearing on stock-market valuation than the level of anticipated earnings," he notes.

Here's the catch: While there is a sound theoretical basis to the widely observed view that equity returns do depend to a significant extent on changes in bond-yield levels, the same idea leads to the conclusion that the influence diminishes as yields drop below a certain level. And U.S. Treasury yields are approaching that level now, the threshold below which the influence of yields on equity returns should cease to be as significant as the influence of changes to the anticipated future value of American companies.

Mutkin's investigation reveals that U.S. fixed-income security yields are now at such a low level that they will begin to have a smaller effect on stock prices than changes in anticipated future cash flows. This is very important, as it suggests that even if yields continue to fall, this effect will no longer support the stock market as long as expectations of companies' future earnings values continue to decline.

Taken to an extreme, Mutkin further notes, the decline in Japanese interest rates to unimaginably low levels (1.215% for benchmark 10-year issue last week) has done nothing to lift the Nikkei. Indeed, the Japanese stock and bond markets decoupled in 1992 when the 10-year JGB yield fell below 5.25% -- not far from the current U.S. 10-year note's level.

U.S. bond yields also never rose as high as 4% between 1925 and 1930, yet Mutkin notes with studied understatement, "the U.S. stock market exhibited considerable volatility during that same period."

Interestingly, bond yields didn't plunge as money flowed out of the stock market last week. After all, isn't that what is supposed to happen when the Dow stumbles? Don't investors typically flock to the relative security of U.S. Treasuries? The answer to both questions is yes. But things didn't go as planned last week, as investors figured bonds, which have seen their own rally this year, also have gotten a bit rich. There's little chance of a Fed rate cut any time soon. The dollar's strength appears to be waning. And corporate bond supply is abundant. All of this has locked Treasury yields in place for now. "It's a matter of simple economics," notes Barbara Kenworthy of Prudential Investment Advisors. "With no recession on the horizon and the Fed on hold, the bond market yields can't go much lower."

Indeed, the Fed could force the issue by slashing short-term rates in response to an ugly decline in stocks. But for an institution that has long worried about "irrational exuberance," as Fed Chairman Alan Greenspan put it 18 months and more than 2,000 Dow points ago, a decline in the Dow would not necessarily be an unwelcome development, as long as it's an orderly one. Indeed, Greenspan warned just last month about overly optimistic assumptions of corporate earnings growth.

This does not mean that the Fed won't cut rates if and when the equity bubble bursts; it's a safe bet the central bank will do its job to maintain liquidity in the banking system. But it does mean that the Fed may not be as quick to pump liquidity into the banking system, even if the Dow experiences a 10%-20% downward correction over time, provided there are no spillover effects into the rest of the financial system. And even if the central bank does cut rates, say, to counter the effects of a renewed meltdown in Asia or Russia, looser monetary policy may not be enough to help the U.S. equity market.

Clearly, an orderly correction in equities could keep the Fed from boosting rates as it otherwise might in view of traditional indicators such as rapid money-supply growth or rising wages. Gains in the equity market are a major force behind consumer spending right now. Consider that consumption grew at a 6% pace in the first half of the year, while real income grew at a 3.5% rate and household savings were essentially flat at end of the second quarter. It's the stock market and the increase in household wealth that is making up the difference. "The U.S. economy is running on capital gains," says Gerald Guild, chief taxable fixed-income strategist at Advest.

As long as bond yields don't surge, the nation's rate structure won't be a negative for stocks. Johnson of First Chicago says a big factor in the stock market's rally has been the drop in the 10-year Treasury yield from 7.75% at the start of 1995 to around 5.40% today. As inflation expectations fell and nominal interest rates moved lower, investors were willing to accept lower earnings yields (the flip side of higher P/E multiples) on stocks. At present, the spread between the 10-year Treasury yield and the earnings/price ratio is somewhat wider than usual, suggesting that stocks are relatively expensive compared to bonds.

A more normal spread could be established in a number of ways. Earnings could rise briskly, bonds could rally further or stocks could sell off. But with profit margins likely to be squeezed by tight labor markets, intense foreign competition and flagging productivity, improved profit performance seems unlikely. The more likely outcome, analysts say, is that the current spread will be narrowed by the bond market outperforming stocks for a while. And given that bond yields have little room to fall, bonds merely would return their coupon income. That income is matched by short-term rates, which helps explain the rush into money funds. Under such a scenario, cash no longer is trash.

Johnson also notes that the performance of the equity market tends to be related to the shape of the Treasury yield curve. Since 1965, the 10-year Treasury yield has averaged 76 basis points (hundredths of a percentage point) more than the one-year Treasury yield. When that spread was 38 basis points or more (as it was 63% of the time) equity investors were well rewarded; the S&P 500 returned nearly a percentage point per month more than T-bills. When that yield spread was between nil and 38 basis points, the S&P trailed T-bills by an average of one-fifth percent per month. And when the spread was negative, T-bills outreturned stocks by nearly three-quarters percent a month.

At present, the spread between the 10-year and one-year yields is about 10 basis points. So if history is of much help here, it suggests the stock market is likely to underperform Treasury bills by a modest amount so long as the yield curve remains relatively flat. Adds Johnson: "I think stocks are a sale for now."

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